The Bank of Japan Didn’t do it; China Did; Dollar Implications & a Trade Setup (Aussie)

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Friday 30 October 2015


“Because here's something else that's weird but true: in the day-to day trenches of adult life, there is actually no such thing as atheism. There is no such thing as not worshipping. Everybody worships. The only choice we get is what to worship. And the compelling reason for maybe choosing some sort of god or spiritual-type thing to worship—be it JC or Allah, be it YHWH or the Wiccan Mother Goddess, or the Four Noble Truths, or some inviolable set of ethical principles—is that pretty much anything else you worship will eat you alive. If you worship money and things, if they are where you tap real meaning in life, then you will never have enough, never feel you have enough. It's the truth. Worship your body and beauty and sexual allure and you will always feel ugly. And when time and age start showing, you will die a million deaths before they finally grieve you. On one level, we all know this stuff already. It's been codified as myths, proverbs, clichés, epigrams, parables; the skeleton of every great story. The whole trick is keeping the truth up front in daily consciousness.”

― David Foster Wallace, This Is Water: Some Thoughts, Delivered on a Significant Occasion, about Living a Compassionate Life

Commentary & Analysis

The Bank of Japan Didn’t do it; China Did; Dollar Implications & a Trade Setup (Aussie)

Despite indicating the economy is weak and may be getting weaker, the Bank of Japan (BOJ) decided to pass on adding additional stimulus to the economy.  One might think ¥80 trillion ($660 billion) a year in quantitative easing was enough, but a decent slug of economists expected more.  The yen, in a volatile session today, has rallied on the news.  But here is the payoff summary from The Economist:

Policymakers at the BoJ are also more aware of the risks associated with expanding monetary easing than they were a year ago. A weaker yen constrains consumer spending and raises costs for small- to medium-sized businesses. The bank recognises that the scale of its QE purchases is stifling the world’s second-largest sovereign debt market. None of that, however, will dent financial markets’ expectation that weak growth and sluggish prices will make further easing inevitable in the months to come.

USD/JPY Daily: Below 120.14 sets up 118.00 with potential to 112…above 121.72 sets up potential to 124.00…hmmm…

But here is the rub if the yen rallies sharply, the US dollar index likely fades.  Today we are seeing the dollar hit on weaker than expected personal spending and income…that being said, US 2-yr rates, which are a pretty good indication of dollar price action as it relates to US spread advantage, haven’t given back the gains they made on the Fed “Star Chamber” perceived language change on Wednesday.  

US Dollar Index:  Still correcting or is the bull back?  The big question indeed!  Could be tracing some type of wedge with an appropriate target to 92.20 (that would represent a 38.2% standard retracement of Major up Wave 3)…but one can make the case the correction is complete at label C, which was close to 38.2%...a standard three-wave correction and the bull is back. 

I think for confirmation the bull is back, means the index has to pierce above the daily swing high resistance at 98.33 (labeled Wave B).  Till then, given the continued soft US data, and based on the continued confusion from the “Star Chamber”, which by the way should not be confused as a Chamber of Stars, and its seemingly rampant love of the dove one has to be very suspect the bull is back in town.  

So what is our favorite idea if the dollar stages a multi-week correction back to 92.20 or 89.65 which would be 50% retracement?  We like long AUD/USD which seems it could still be in the midst of a major correction higher.

I guess to sum up the macro themes I would stress these simple points:

  1. Data of late out of Australia not too bad.  Many expected much worse (including your editor) given the crush down in all things commodities and loss of altitude from the mothership—China.
  2. The Reserve Bank of New Zealand had a chance to cut rates, to express another degree of panic about China, but didn’t.  My guess the Reserve Bank of Australia remains on hold too when it meets on November 5th.
  3. China’s decision to intervene and push up the value of its currency today.  “The renminbi posted its biggest one-day gain ever on Friday, as traders said China’s central bank appeared to have intervened to boost confidence around the release of a big economic development plan,” writes Gabriel Wildau in today’s The Financial Times.

Call this what you will—window dressing for entry into the IMF Special Drawing Rights basket; or an attempt to bolster bank balance sheets at the end of the month; or a ploy to increase confidence in foreign direct investment; or a way to signal Chinese development bonds to fund the new Asian Infrastructure Investment Bank (AIIB) will be cared for resposibly; or pie in the sky—it could be a move which takes some pressure off the Asian currencies and comdols in the region.  It may also be part of the mix as to why the yen has rallied sharply today. 

As a footnote to the AIIB argument, there are two theories: The first sees China’s new development bank as a serious challenge to the World Bank and IMF; two increasingly flawed Western institutions long in the tooth.  This from William H. Overholt, writing in 2015 Summer edition of The International Economy,”The Enemy is US”:

The preeminence of the dollar derives from the superior liquidity of dollar markets and from confidence that the U.S. Federal Reserve and the U.S. Treasury will provide liquidity in crises. Dollar liquidity has declined but remains greatly superior to all alternatives. Trust that the United States will help in crises has, however, been shattered, particularly in Asia. In the Mexican crisis of 1994, the United States used its Exchange Stabilization Fund to prevent Mexico’s currency crisis from becoming a catastrophe. The Mexican intervention cost the United States nothing, but Congress prohibited future similar interventions. When the Asian crisis began in Thailand in July 1997, the United States therefore could not intervene and some of America’s strongest Asian allies felt abandoned. Punitive IMF conditions crashed Thailand’s economy and collapsed Indonesia’s banking system. In a precursor of the Asian Infrastructure Investment Bank controversy, the United States insisted that Japan withdraw an offer to create a recovery fund that the United States feared would compete with the IMF. Therefore, in Asian eyes, the United States was accountable for catastrophic IMF policies; distrust for the U.S.- Bretton Woods system persists. Key Congressional restrictions continue. The United States has five standing swap agreements worth $333 billion; China has twenty-eight worth $499 billion. While the U.S. executive has always backed the Bretton Woods system, Congress has undermined it. The World Bank and the IMF were designed, at Bretton Woods, for the world of 1944, in the scale of their resources and the structure of their governance. Afterward, presidents of both parties consistently supported augmentation of their resources to cope with a growing global economy. But from 2009, Congress has rejected this bipartisan tradition. That refusal led directly into the recent controversy over China’s founding of the Asian Infrastructure Investment Bank. Outside Washington, the AIIB debate has focused on the scale of need, $8 trillion of investment over a decade. The World Bank ($223 billion) and the Asian Development Bank ($168 billion) have a combined capital of $391 billion. China and virtually all U.S. allies and the U.S. administration pressed for that capital to be increased, but Congress refused. China wants to strengthen these institutions; it is the U.S. Congress undermining them.

…The United States has three options: update existing institutions sufficiently that they can provide leadership; refuse modernization and embrace new institutions that fill the resulting vacuum; or refuse modernization of the Bretton Woods institutions and oppose new ones. The first two options both provide a decent chance that the United States will remain the preeminent economic leader, albeit with more influential colleagues. Ironically, Congressional choice of the third option ensures that the new institutions will be preeminent and that China will be preeminent within them.

The second argument, this time from the editor of The International Economy, David M. Smick, sees some desperation on China’s part as a core rational for AIIB:

The counterintuitive view holds that the AIIB may be less a brilliant move on a chessboard and more a defensive ploy, or even desperate effort.  The Chinese economy, the argument goes, is in a precarious position.  Most Chinese manufacturing industries have experienced huge growth in oversupply capacity.  In the last dozen or so years, China has experienced a domestic investment explosion equivalent in terms of urban infrastructure, residential, and commercial real estate to the building of 320 Manhattans.  Yet the economy has still weakened, which is why the Beijing leadership took the unexpected step recently of devaluing its currency. 

Today, half of China's debt may now be unserviceable. Several years ago, China's debt could still be financed by domestic savings. Not anymore. China's private sector borrowing in part to finance such investment has skyrocketed to between $2-$3 trillion. Because a lot of that debt is dollar-denominated, it is easy to see why IMF had Christine Lagarde is so nervous about the Federal Reserve raising short-term interest rates. The Fed is a central bank to the world. And a stronger dollar as a result of Fed tightening's, combined with Beijing's efforts to weaken yuan, could risk some form of the fault, or disguised the fault, of dollar-denominated debt.

The AIIB is an attempt to resolve China's huge oversupply capacity problem. In cement, steel, and other elements of infrastructure improvement and expansion, China may be sitting on half the world supplies at a time when the global economy has weakened and China's trade in both dollar and volume terms is shrinking. Such a mind boggling excess capacity, critics charge, is far larger than China can use even under the rosiest of future GDP growth scenarios. Therefore, the only possible place in the world where such supply capacity can be deployed is elsewhere in Asia with a dramatic increase in infrastructure spending. Thus the need for the AIIB.

I think it would be fair to say the second argument makes sense as it relates to China’s oversupply.  But from a strategic perspective, it seems brilliant strategy.  Already key US allies have committed to the AIIB.  The UK political leadership necks seem to have taken on a particular Asian shade of brown given their gyrations during Chinese President Xi’s latest visit.  If the US’s perceived strongest ally is becoming brown-neck like cozy with China, it’s no stretch to say US influence in the world is waning. 

We are long AUD/USD as of today…the setup appears promising, but as always there are no guarantees in this game.

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Jack Crooks

President, Black Swan Capital

Twitter: @bswancap